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Lease-purchases have always been a favorite tool of residential real estate investors. They are one of the “Big Three” - alongside contracts for deed and lease-options - all of which are creative devices for getting less than fully-qualified buyers into a home. These contracts have been traditionally popular in Texas for two reasons: first, it was easy to get tenant/buyers into the home by offering a low down payment; and second, it was easy to evict them through the forcible detainer process if they defaulted (and still keep the down payment).

In a typical lease-purchase, a portion of each monthly rent payment is (allegedly) set aside and credited toward the tenant/buyer’s down payment.  After a certain amount is paid in, then the tenant is able either (1) to convert the transaction from a lease to an owner-financed sales transaction in which the tenant gets a deed and gives back a note and deed of trust to the seller; or (2) the seller agrees that the tenant/buyer may show the accumulated down payment on a loan application to a third-party lender and thereby qualify for financing elsewhere.  

Another form of this arrangement provides that payments will continue over a number of years until the property is paid for.  But guess what?  This isn’t a lease-purchase anymore.  It’s a contract for deed, which along with options to purchase presents serious challenges under the Texas Property Code.

The problem with most lease-purchases is that they go on to state that once a sufficient down payment is paid in, then the tenant/buyer will have an option to purchase the property at a certain price. Result? The lease-purchase has become tangled up with a lease-option - and this is its downfall.  The document has become a hybrid: a “lease-purchase-option” that is subject to Chapter 5 of the Texas Property Code.

Why is this a problem?  Because changes to Chapter 5 made in 2005 define residential lease-options for longer than 180 days as “executory contracts” that are subject to strict regulation and penalties if not done exactly right.  Contracts for deed also fall into this category.

The statute provides that numerous initial and ongoing requirements must be observed, and the burden is on the seller to meet these. Failure to do so incurs not only penalties under the Property Code (the return by the seller of all payments made by the buyer, including the down payment and monthly payments) but liability under the Deceptive Trade Practices – Consumer Protection Act, which can involve treble damages plus attorney’s fees. Even in smaller transactions, these can turn into big numbers quickly. Note that Chapter 5 includes no seller defenses.

The risk to the seller of using lease-purchases-options is now significant, and investors have therefore moved away from this device in favor of wraparounds and land trusts.

Lease-purchase-options may theoretically be used if the term is less than six months, although this is such a short period of time most tenant/buyers will not be able to accumulate much of a down payment.  So what about the possibility of “stacking” six-month contracts – i.e., allowing the lease  to expire and then renewing it every six months?  This does not violate the letter of the law; however, if long-term stacking was the intent of the parties from the beginning, it is likely that a judge will see through this and find that the arrangement is indeed an executory contract that violates the statute.

Will an investor be caught if he goes forward with a lease-purchase-option in spite of the statute?  Maybe, maybe not.  There are no “executory contract” police.  It all comes down to whether or not the buyer becomes dissatisfied and decides to challenge the transaction with a lawsuit.

Because of the burdensome requirements of Sec. 5.061, a landlord/seller may be tempted to re-write the traditional lease-purchase in an attempt to call it something else or make it appear as if it is something else.  The important point to remember is this: if it’s an “executory contract,” then Sec. 5.061 applies - regardless of the title or wording of the document. 

So . . . What exactly is an executory contract? Executory contracts include any transaction that defers some action by either party that pertains to ownership or possession of real property into the future.  Think of it this way: an “executed” contract is one that is fully performed today. It is done, finished. An “executory” contract, on the other hand, leaves something dangling. Usually the dangling item is the most important item of all, namely, who owns the property and when do they get the deed?

Executory contracts can often be recognized by their similar structure. Typically, one party (the seller) holds “legal title” to the property.  This usually means he retains a deed to the property in his name. The other party (the buyer) holds “equitable title,” meaning that he has only an equitable right to receive legal title at some time in the future if certain conditions are met. This arrangement gives an advantage to the seller, because enforcement of “equitable rights” by a purchaser generally involves filing suit and asking that one’s equitable rights be recognized by a court and enforced - a lengthy and expensive process at best. Buyers under financial pressure are more likely to abandon their option rights along with their down payments.

In the past, unscrupulous sellers abused executory contracts by disregarding the buyer’s equitable rights and representing to Justices of the Peace that such buyers were ordinary tenants subject to ordinary leases.  Sellers were then able to obtain evictions for minor or technical defaults, often confiscating large down payments in the process. The seller was then free to move on to his next “victim” and obtain another down payment. The legislature rightly acted to stop such abuse.

Make no mistake, one can still do a transaction by means of an executory contract - but many requirements now exist that did not apply before the 2005 revisions to the Property Code. Sections 5.069 and 5.070 contain a number of these requirements, which must be met before the executory contract is signed by the purchaser:

What happens if the foregoing requirements are not met? Firstly, failure to do so is defined as “false, misleading, or deceptive act or practice” under the DTPA (Sec. 17.46, Texas Business & Commerce Code); secondly, the purchaser is entitled under Sec. 5.069(d)(2) to “cancel and rescind the executory contract and receive a full refund of all payments made to the seller.” That would include any down payment plus monthly payments that have been made.

Note that Sec. 5.074(a) entitles a purchaser to cancel an executory contract for any reason within 14 days of signing, even if all of the statutory requirements have been met.

An additional pre-closing requirement is imposed by Sec. 5.071, which requires that the seller provide a thorough disclosure of the financial terms of the transaction, including the interest rate, amount of interest charged for the term of the contract, the total amount of principal and interest to be paid, and the non-existence of a pre-payment penalty. There is some slight relief under this section in that violation of it is not defined as a DTPA violation. 

Another, related pre-closing requirement is contained in Sec. 5.016, which states that “A person may not convey an interest in or enter into a contract to convey an interest in residential real property that will be encumbered by a recorded lien” without giving a 7 day notice to both the lender and the purchaser.  The section sets out the required content of this notice, which is quite technical.  It should be observed, however, that this odd statute provides no real penalties other than to allow the purchaser to back out of the transaction prior to closing if the 7 day notice was not given. 

Sec. 5.073 prohibits these.  Excessive late fees are banned, as a pre-payment penalties and any clause that “prohibits the purchaser from pledging the purchaser’s interest in the property as security to obtain a loan or place improvements. . . .”

In the past, lease-options did not need to be recorded in the real property records. No longer.  Sec. 5.076 states that “the seller shall record the executory contract, including the attached disclosure statement . . . on or before the 30th day after the date the contract is executed.  Additionally, any instrument that “terminates the contract” must also be recorded.

Sec. 5.077 requires that the seller provide an annual accounting statement every January, which must include the amounts paid, the remaining amount owed, the number of payments remaining, the amount paid in taxes, the amount paid for insurance, an accounting for any insurance monies paid by the insurer, and a copy of the current insurance policy.

The buyer has an absolute right “at any time and without paying penalties or charges of any kind” to convert an executory contract to “recorded, legal title” under Sec. 5.081.  The seller has no choice in the matter so long as the buyer tenders the balance owed under the contract.

It is not permissible to simply evict a tenant/buyer under one of these contracts if there is a default. Sections 5.063 and 5.064 specify the content of a notice of default, which must be followed to the letter if it is to be valid.  The tenant/buyer is allowed 30 days unconditional right to cure the default.  Moreover, if the tenant/buyer has paid in 40% or more of the purchase price, then a 60 day notice is required and, if the default is not cured, then a traditional foreclosure (not an eviction) must be used to regain possession and title (Sec. 5.066).

Why not just ignore the executory contract rules and march merrily forward?  The reason is that courts and juries generally do not favor investors and landlords, who are often perceived as profiteers preying upon the weak and helpless.  It often does not matter how clever your legal argument is. If a transaction does not pass the “smell test” a seller/landlord will likely lose.  Underestimate a jury of 6 or 12 of your peers at your peril.  Even if the executory contract rules are found not to apply, remember that the court can look to the “laundry list” of offenses under the Deceptive Trade Practices-Consumer Protection Act. Section 17.50(a)(3) of the Act prohibits “any unconscionable action or course of action by any person” – an exceptionally broad statement.

Forfeiture remains a hot-button area. Section 5.073(a)(4) prohibits a forfeiture of a buyer’s down payment or option fee if a monthly payment is late.  This is an important change, because it codifies what judges and juries have been telling lawyers for quite some time.  They hate forfeitures.  The trend in the law is to view any substantial forfeiture as unreasonable and unconscionable, whether within the context of an executory contract or not, if it results in a buyer losing either a large down payment or the home itself.  

The answer is “yes,” there is a way, so long as the lease-purchase is not joined with an option to purchase. Instead, it may be combined with a “right of first refusal” (ROFR). 

What’s the difference? An option to purchase is a unilateral contract which gives the holder of the option (the tenant/buyer in this case) the right to compel sale of the property at certain price.  It must be in writing, exercisable within a specific term, and either recite a price or a formula to compute a price. 

By contrast, a ROFR merely requires the property owner, when and if he or she decides to sell, to first offer the property to the prospective buyer – our tenant/buyer in this scenario. Depending on how the ROFR is worded, the seller may be required to first negotiate a specific deal with a third-party buyer and then freeze that transaction momentarily while the holder of the ROFR is given a chance, for a specified time, to buy the property at the same price and terms. Often the price is to be determined by what fair market value is at the time of sale. Careful: As soon as you include a specific price, it is likely that an ROFR will be interpreted as an option - then you’re back to the executory contract rules.

All of this may present an issue for a careful investor, since ROFR’s by definition do not establish a pre-set price that locks in a guaranteed profit.  The market could go up, it could go down.

There are two other possibilities that utilize lesser forms of preferential or pre-emptive
right:

Be cautious in the use of lease-purchase forms - or any forms - from “guru” seminars or obtained off the internet. These forms are always suspect since they are not usually designed specifically for Texas. They can get you in real trouble. If you have such forms entitled Purchase Option Agreement, Option Cancellation and Release Agreement, Option to Purchase Real Estate, Performance Mortgage to Secure Option, Secured Reverse Assignment Agreement, Slick Tricks to Get What I Want Without Telling Anyone What I’m Doing, and the like, they are toxic waste.  Throw them away.  One can call a cat a dog but that does not change the nature of the beast. Courts look to substance over form.  Moreover, a judge and jury will likely be angry with a seller who tries to pull a fast one with overly-clever verbiage - and more inclined to consider a finding of fraud.  Remember: juries are predisposed to view investors as predatory pariahs.

Find a good real estate lawyer, one with courtroom experience, and consult him regularly.  His fees are cheap insurance. Pay attention to what he says about how a judge or jury will react to your proposed deal.  A good lawyer knows that documents should be drafted as if you will one day have to defend them in court.

Lease-purchases may be used so long as they do not include an option to purchase.  Writing them is the legal equivalent of brain surgery.

Information in this article is proved for general educational purposes only and is not offered as legal advice upon which anyone may rely.  The law changes. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences.  Consult your tax advisor as well.  This firm does not represent you unless and until it is retained and expressly retained in writing to do so.

Copyright © 2011 by David J. Willis. All rights reserved worldwide. David J. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his web site, http://www.LoneStarLandLaw.com